Why Venture Funds Don't Want Your Cash

By GARY RIVLIN

Published: July 18, 2004

PALO ALTO, Calif.—
THE partners at Sevin Rosen, a top venture capital firm, were braced for the worst last November, when they began passing the word that they wanted to raise a few hundred million dollars to invest in a new generation of technology start-up companies. After all, the venture capital business had just experienced the worst slump of its 30-year history. And if not entirely at fault for the bubble, the industry was not exactly blameless, either.

''Given all that's happened in the last three years,'' said John Jaggers, a partner at the firm, ''I would've thought a lot of people would've learned the lesson 'once burned, twice shy.'''

Instead, Sevin Rosen was inundated by would-be investors. On July 8, the firm announced a new $300 million fund, but Mr. Jaggers said it could have raised at least five times that much. Potential investors, many from Europe and Asia, called out of the blue; some even provided references in the hope of persuading the partners to take their money. ''We were just swamped with interest from new investors,'' Mr. Jaggers said.

Sevin Rosen, which has offices in Silicon Valley and Dallas, is hardly the only venture firm to be deluged lately with offers of money. After a hiatus, other top-tier venture funds have also started raising new funds in recent months, and some are turning away hundreds of millions in potential investments.

That may seem a happy turn of events for the tech industry, in sharp contrast to the jittery pronouncements of pundits over the last couple of weeks, wondering if climbing inventories and an assortment of other bad news portend harder times. Yet even the venture capitalists seem a bit nervous.

''Everybody wants into venture capital, but we'll have to wait to see if that's a good thing or a bad thing,'' said Ted Schlein, a partner at Kleiner Perkins Caufield & Byers. Like Sevin Rosen, Kleiner Perkins rejected far more money than it accepted when it closed on a $400 million fund earlier this year.

The question is what will happen to all those millions that do not get into top-tier funds like Kleiner Perkins or Sevin Rosen -- money that plenty of other venture capitalists would be happy to accept but would not necessarily be able to invest effectively, given a limited pool of bankable ideas. And if too much venture money chases too few deals, the industry may have another mess on its hands.

''When the venture industry went from 300 funds to 1,000'' during the second half of the 1990's, Mr. Schlein said, ''everyone knew that didn't make sense, and assumed we'd drop back down to 300.''

So far, however, very few firms have shut their doors, according to data provided by the National Venture Capital Association. With all the capital that wants into venture, Mr. Schlein added, ''we could end up going from 1,000 funds to 990.''

The typical venture fund lasts five or more years. Investors, called limited partners, contribute money to a pool that a firm's general partners then invest in business ventures. The aim is to choose start-ups developing a technology so promising, or pursuing a market so attractive, that the business will quickly go public or be acquired by a more established company, parlaying a modest investment of, say, $5 million into $50 million or more.

Once a venture firm has cashed out one of its investments, it then splits the profits with its limited partners after taking a share for itself -- typically 20 to 25 percent.

One obvious explanation for the surfeit of cash trying to get into venture funds is this: the firms are raising considerably smaller funds. Sevin Rosen, for instance, secured commitments for $875 million the last time it raised a fund, in July 2000, and though the partners collected only $600 million after realizing that they had asked for too much money, that is still twice the size of the firm's new fund.

Similarly, Kleiner Perkins, based in Menlo Park, Calif., closed on a $400 million fund earlier this year -- half the size of the pool the firm raised in 2000. Kleiner Perkins spent only $625 million of that amount.

More dramatically, Charles River Ventures, a top firm in the Boston area, raised a $1.2 billion fund early in 2001, cut that commitment to $450 million, and earlier this year closed on a new $250 million fund.

But venture is again a hot area for investment, mainly because, with the exception of the late 1990's, it has been a great bet. Notwithstanding all those billions that venture capitalists invested in disastrous dot-coms and telecom sinkholes in the bubble years -- and lost when the bubble popped in early 2000 -- the average venture fund raised from 1992 to 1994 earned its limited partners more than 20 percent a year. Those fortunate enough to be in funds raised from 1995 to 1997 earned, on average, more than 50 percent a year.

''If you look at long-term returns over the past 10 or 20 years, you see that venture capital provides the best returns,'' said Anthony Romanello of Thomson Venture Economics, a research firm. As a result, Mr. Romanello and others say, everyone from the wealthy of Europe and Asia to pension fund managers who were late to recognize the value of this asset class want into American-based venture capital firms.